A Chat With Vanguard Canada: Part 2

Here’s another excerpt from my recent interview with Atul Tiwari, Dennis Duffy and Joel Dickson of Vanguard. These questions focus on the types of products we might see from Vanguard in the future. You can read also read Part 1 of the interview here.

Your first family of ETFs have all been plain vanilla funds that track major third-party indexes. What new products are on the horizon?

AT: We’re in the development and design stage for the next suite of ETF products that we’ll launch next year. Before we make any decisions about what those will be, we want to be in the market, talking to clients, talking to advisors, and then we will try to reach a conclusion about the next tranche.

The interesting thing that we have come across in terms of how to bring passive investing to Canada is that the index mutual fund market in Canada is pretty small. It’s concentrated in a few issuers and products that really don’t get much prominence. So we have seen indexing growing in Canada, but clearly the vehicle of choice is ETFs. The growth in the ETF market has been 30% or 35% per year, and predictions are $105 billion by 2016.

The main reason index mutual funds are not popular in Canada is that they’re way too expensive. So it seems to me there is a huge opportunity for someone to come in and grab that space.

AT: We have to start somewhere. You alluded to this idea when you asked about what we are bringing other than passive ETFs that already exist elsewhere, and we obviously think that it is not just low-cost. Our ETFs are the low-cost leaders in the market now, and we all know that low costs are important. But we also are bringing the thought leadership and the education.

The other big difference is our ownership structure: we are a client-owned organization, and we really do put clients first. We are all about continuously finding ways to lower our own costs so we can lower the costs of our investments for clients, and that’s unique. It’s not just unique in Canada, it is unique globally.

Can you explain how Vanguard’s ownership structure works, because there is a lot of confusion around that. I have heard Vanguard described as a nonprofit company, for example, which is clearly not accurate.

AT: The way it works is that in the US, the clients of Vanguard own the funds and ETFs, and in turn the funds and ETFs own the management company. So we are not a public company, but we’re not a private company either in the classic sense of being owned by a family of shareholders. It’s more like a mutual. We are a for-profit company, but we give all the earnings back to clients in the form of lower expenses.

JD: The management company derives profits from its activities, and those profits are paid to the owners, who happen to be the investors in the US funds. Instead of being paid as a dividend, it is paid in the form of lower expense ratios.

DD: We have thought about it and I can tell you it is definitely something we are considering when we look at what we will be rolling out in the second tranche. We have done that in other jurisdictions, where we have offered both hedged and unhedged versions. So that’s definitely something we have looked at and will give it some consideration.

Vanguard offers a family of target retirement funds in the US. There seems to be few of these available in Canada, and I have a theory about why. If an advisor says to a client, “I’m going to put you in this target date and we won’t need to switch for 25 years,” the first thing the client is going to say is, “Then why the heck am I hiring you?”

JD: Even among advisors who buy into our philosophy, target date funds are not a huge seller, because advisors do view their job as asset allocation. Even if it is long-term strategic allocation, they want to build that for you rather than having it pre-packaged like a candy bar you buy in the store. So that is a hurdle. We get a lot of questions about how we might create target date funds out of our ETFs, but it’s just not clear what the distribution would be for a product like that.

DD: Much of the appeal of our target date funds has been in the retirement segment, for defined contribution investors. We just launched a series of target date funds in the UK, and that is also something we are looking at as we consider future opportunities in the Canadian market, where there is a huge number group RRSPs and defined contribution plans.

One of the alarming trends in Europe is the move towards synthetic ETFs. Is there any plan to move away from the physically backed ETF model that Vanguard has made its bread and butter?

DD: If we look at what we have launched in the US, the UK, Australia and Canada, having full-replication, asset-backed securities, as opposed to swaps, makes a lot more sense. I would never say never, but it is definitely not the direction that we are planning to go in.

JD: We have 35 years of experience managing physical, full-replication index funds, and that works great in large, liquid, diversified markets. There could be a role for synthetics in hard-to-access markets, where there might be some liquidity issues—where there might be restrictions on your ability to access those markets. Synthetic by itself is not the issue: it is how you negotiate the swap contracts.

20 Comments

gsp
December 22, 2011 at 7:52 am

Overall a disappointing interview IMO. You tried but they weren’t saying much. It is pretty funny seeing questions from a DIY perspective and getting replies from their corporate viewpoint. Nowhere is that more evident than your question invoking low costs as the reason index MFs are not more popular. You can just about see the machinations in their brains; e-series has few assets… the thousands of MF salesmen(masquerading as financial advisors) won’t sell them unless they get their kickbacks… no money in it for us.

The only question I wish you’d have asked is why we can’t get real Canadian domiciled products rather than international clones tailored for the US market that suffer from double taxation. Low MERs are great but in the end it’s total costs that matter and the cookie cutter nature of their products leaves less in investors’ pockets than could otherwise be achieved with true Canadian funds/ETFs.

The one positive takeaway from the interview is more products are coming, more choice is always a good thing.

@gsp: I obviously share your disappointment about the decision not to launch index mutual funds, but it is hard to blame a company for not wanting to enter a market that has not proved to be lucrative.

As much as I detest the mutual fund distribution model in Canada, the fact is that there are many direct-sold funds available at relatively low cost (PH&N, ING Direct, Steadyhand, Mawer) and investors do not take advantage of them as much as they should. Steadyhand, a company that does everything right in terms of cutting out the middleman and encouraging good investor behaviour, manages only about $120 million. Canadians inexplicably seem to like the hidden-fee, commission-based model. That has to change, and maybe Vanguard can help get the message across in the same way that ING has raised awareness about banking fees.

If so, remember that the Canadian ETFs piggyback on the the scale of Vanguard’s US and international funds, which allows them to be dramatically cheaper and have lower tracking error than if they were recreated for Canada.

Raman
December 22, 2011 at 8:45 am

Well, I don’t think the interview was a disappointment. I’m pleased that they will probably be creating non-hedged versions of their US and international equity ETFs — although a timeline as to their implementation would have been nice :)

@gsp – If you want Vanguard to actually succeed in Canada, you want them to be sensitive to distribution. Many companies have come and gone because they relied solely on selling funds direct to the investing public. ING has done okay (~$600M)but they’ve seemingly dumped a lot into advertising. Steadyhand has been around for 4(?) years, gets a bunch of positive press and has amassed (last I checked) much less than $200 million.

As for the increased “cost” of taxation, remember (as DanB notes) that their overall cost efficiency is valuable. Claymore’s own emerging markets ETF is a case in point. Vanguard’s low-cost entry has forced Claymore to shift from its previous strategy of simply holding Vanguard’s U.S. traded EM ETF and charging a fat premium for it. Claymore’s version has now dumped Vanguard EM in favour of PowerShares RAFI EM. Not sure that’s a sustainable strategy either but they had to do something.

Point being that Vanguard has uniquely Canadian offerings (Cdn stocks + bonds) and is putting price pressure on all categories in which they have products. What else could you ask for (other than mutual funds)? And in time, if Canada is a success, we may have Vanguard mutual funds in time. It’s costly to launch mutual funds so they’ll want to be absolutely sure about attracting enough money.

The lower fees on the Premium class CIBC index funds seem to apply only to investors with at least $50,000 per fund (as opposed to a $50,000 total investment). At that point, I have to wonder why you you wouldn’t just go for an ETF, but I suppose it’s a lot better than their standard fee of more than 1%!

I had not noticed that Claymore changed the strategy of CWO. That’s an interesting development, because the underlying PowerShares ETF has an expense ratio of 0.85% and CWO still lists its own fee as 0.71%. That clearly can’t last for long.

Bruce
December 22, 2011 at 10:30 am

TD eseries EAFE mutual fund has an MER of 0.50% (the currency hedged version is 0.52%). iShares currency hedged EAFE ETF has an MER of 0.55%. Vanguard EAFE ETF has an MER of 0.42%.

The TD mutual fund is Canadian domiciled. The iShares and Vanguard funds are wraps of American domiciled ETFs. The MERs aren’t greatly different; the TD fund is actually cheaper than the iShares fund. And conventional wisdom is that mutual funds tend to be a bit more expensive to run than ETFs.

About tracking error, I don’t have any data to compare the two fund structure types. But iShares EAFE fund has $838 million in assets. At that level of assets, I wouldn’t be surprised if tracking error on a Canadian domiciled ETF would not be significantly different that the presently used wrap structure.

You will see that XIN outperformed the equivalent TD e-Series fund by 60 basis points. The tracking error on Vanguard’s VEA (the underlying fund in XIN) was actually +0.72%, which is remarkable (through probably more lucky than anything else). See the comments section of the above post for Vanguard tracking errors.

Bottom line, if you can get around the currency exchange costs during the transactions, Vanguard’s US-domiciled ETFs are often the best way for Canadians to get US and international exposure, especially in an RRSP.

gsp
December 22, 2011 at 10:59 am

@CCP, yes in part but there are other issues. Have you seen the nasty distributions spit out by Vanguard Canada’s new international ETFs after 2 weeks of existence? Here are discussions on those and other issues.

Probably shouldn’t have said the interview itself was a disappointment, I enjoy these type of blog entries very much. My disappointment was simply in the interviewees’ reluctance to actually say anything substantive. Lots of marketing speak, little steak. Couldn’t help but finish reading the interview with a diminished opinion of Vanguard Canada and that’s saying a lot considering how highly I think of Vanguard in general.

@DanH, thanks for the insider’s perspective. I like the domestic offerings, not so much the international ones. What more can I ask for? How about something comparable to what I get from their US ETFs at only an incremental price increase? There are lots of things to ask for, see the threads I linked above for a laundry list. Yes, I know they won’t all happen but some of us hold VG to a higher standard and if they want to keep on the “thought leadership and the education” bandwagon they’ll need to address some of these issues. Let’s see what happens, no one has ever accused me of being patient. :)

@gsp: I am not a tax expert, but I think some of the assumptions in those FWR threads are not accurate. Withholding taxes on foreign dividends must be paid by investment funds whether they are ETFs or mutual funds. There seems to be an assumption that Canadian-domiciled mutual funds are somehow more tax efficient, but I don’t think this is true—certainly that is not borne out by the performance numbers.

As for expecting Vanguard to launch US and international ETFs at price points similar to their US offerings, there is simply no scale to allow them to do that. VTI, for example, has about four times the asset base of the entire Canadian ETF market—that’s why it can afford to charge 7 bps.

Of course, Canadians can already buy VTI, VEA, VWO and others to take advantage of those low fees. The real underlying issue is the outrageous currency exchange fees charged by brokerages when trading US-listed ETFs, which one cannot blame on Vanguard.

Bruce
December 22, 2011 at 1:29 pm

I agree that withholding taxes on foreign dividends must be paid regardless of fund structure. However, if a Canadian uses US domiciled ETFs that invest outside the USA or Canadian domiciled ETFs that invest outside the USA and are wraps of US domiciled ETFs, they won’t be able to get foreign tax credit on those withholding taxes. In a truly Canadian domiciled fund, you could.

Your post on tracking error is excellent. Tracking error is a underappreciated issue among Canadian index investors. But is there something about truly Canadian domiciled funds that inherently results in greater tracking error than quasi-Canadian wrap funds or US domiciled funds? I doubt that.

EWC is iShares US domiciled ETF that invests in the Canadian stock market; it has assets of about $4.4 billion. XIC is iShares ETF that is truly Canadian domiciled and invests in the Canadian stock market; it has assets of $1.2 billion. Even when XIC had much lower assets, I never heard the claim that tracking error was lower on EWC than XIC.

About differences in tracking error, economies of scale play a role. Your post would indicate that representative sampling of the index plays a role. I would also speculate that some fund providers are better than others, when it comes to minimizing negative tracking error. I have read that Vanguard is among the best in the world when it comes to that.

I would be interested in a discussion of what the tracking error would be if Vanguard used truly Canadian domiciled ETFs, instead of the present wrap versions.

A small point about using US domiciled ETFs is the exposure to estate tax. At present, it’s an issue for only a few. But IIRC, unless Congress acts, the estate tax in 2013 reverts to starting at an estate of $1 million and is 55%. I strongly suspect that Congress won’t allow that to happen. But any Canadian who invests in US domiciled ETFs has to consider estate tax as wild card. Who knows what it will be in 20 years? And at that time, one may have accumulated significant unrealized capital gains in US domiciled ETFs that make it difficult to get out of them.

@Bruce: Thanks for all of this. I will try to look further into the tax issue and report back. International (non-US) withholding taxes are not well understood, and it’s even hard to find advisors who can help with this stuff.

A couple of responses to your other comments:

– “Is there something about truly Canadian domiciled funds that inherently results in greater tracking error than quasi-Canadian wrap funds or US domiciled funds?” No, it’s just their higher fees and poorer economies of scale. And as you say, some companies with lots of experience simply do it better than others. Tracking an index efficiently is not as easy as people may think.

– Regarding the scale of EWC versus XIC: once you get over $1 billion (actually well before that) you have all the scale you need. But many Canadian ETFs that hold US and international equities have much lower asset bases than that. For example, Claymore only recently began using full-replication strategies with CLU, CIE and CJP because they finally have the scale. For Vanguard to build something like VUS (with more than 3,300 stocks) from scratch in Canada would be incredibly inefficient.

[…] week the Canadian Couch Potato finished up the second part of his Chat with Vanguard Canada: Part 2. Some wonderful advice is contained in this […]

BC_Doc
December 23, 2011 at 1:02 pm

@CCP: Thanks for the great two part interview. Hopefully Vanguard Canada is gleaning lots of good feed-back from sites like yours.

Like many of the folks who have posted here, I would really like to see VTI and VEU (or their equivalent) trading on the TSX. Fees need to be similar to the U.S. domiciled version to disuade me from using Norbert’s Gambit to buy USD and the US version of the fund.

While I am very happy to use ETFs for my retirement savings, I suspect the typical retail Canadian investor is much more comfortable using mutual funds to invest. For Vanguard Canada to gain market share here, I believe it will be important for them to offer low cost index mutual funds similar to what’s available in the U.S.

And count me as one more “no vote” against Canadian dollar hedged ETFs. I much prefer the unhedged versions.

Elmer
December 29, 2011 at 8:24 pm

Why do people prefer the unhedged US ETF’s versus the hedged to US? If we are tracking an index why are we trying to gain on currency? What am I missing or not understanding?

@Elmer: Now that’s a great question, and I wish I had the answer! My guess is that many of them just assume that hedging is done more or less perfectly. Part of the problem is that some funds with hedging track now track an index that assumes the hedging is reset every month. This gives the funds an artificially small tracking error that disguises the true shortfall. I doubt that many advisers know this.

@Elmer: Certainly a price-weighted index like the DJIA is very different from a cap-weighted index, but I think any quantitative measure used as a proxy for a financial market (and which is used as an investment benchmark) can be properly called an index.